26% of Global GDP: Part 2

Some conceptual confusion seems to be surrounding the crisis in the Eurozone, over whether it’s a banking crisis or a sovereign debt crisis.

Answer B.

Why isn’t it a banking crisis, as the pressures on Societe General, Banco Santander, BNP Paribas, Unicredit, and others (see chart in Part 1 of this series) would seem to indicate?

To be sure, the European banks–along with essentially everyone else in the Western world, including notably US households–is desperately trying to deleverage their balance sheets. But they’re actually succeeding at this, as is the private sector in Europe (by and large). The problem with the EU banks balance sheets is not private sector debt but, of course (it seems “of course” to me anyway) sovereign debt.

But first, a detour into whether higher growth could get the EU out of this situation, since high growth is the universal solvent to economic problems.

Not likely.

Here’s the reason:

This shows the productivity of various EU economies versus an index of Germany = 100. The EU zone is the yellow line at the bottom, France the blue line at the top, Spain and Italy inbetween. They are not competitive.

Technically, this shows labor productivity vs cost, meaning you can increase productivity by lowering wages or increasing output or a combination of both. Being less productive than Germany, or than the EU overall, as these FT lines show, does not augur well.

But back to the banks.

EU banks, not incidentally, tend to hold more public debt than US banks, relative to their asset base. But all that means is that if the EU governments achieved the status of sound debt, the EU banks would be sound. The problem is not with the banks.

If we want to re-roll the historical film, we can all agree in hindsight that the key problem leading to the Eurozone crisis was the shockingly flawed mispricing of relative risk within the zone–absurdly in retrospect essentially all private and public debt was priced at close to a single Eurozone reference rate (itself close to the increasingly mythical “risk-free rate.”)

What does this imply for the appropriateness of various solutions being proposed?

A popular suggestion is to give all the banks a tremendous haircut on their sovereign debt holdings, by essentially re-pricing the value to market value (drastically discounted, almost to zero in the case of Greece) on the theory that the banks made poor investment decisions in the past and should be made to pay for the error of their ways today. Yes, true enough; the banks were foolish enough to believe that Greece/Ireland/Portugal–and now Italy and Spain–were too big to fail. The line forms to the left. (Perhaps worse, capital regulatory requirements themselves treated this debt as risk-free, with zero weight in terms of capital allocations.)

I think a more reasonable approach is to acknowledge that the root problem is the enormous public sector debt overhang, compounded by the complete lack of any apparatus for burden sharing across countries who are facing different degrees of difficulty in servicing their debt.

George Soros, writing in The New York Review of Books, traces the genesis of the problem to Angela Merkel’s decision in November 2008 (immediately after the fall of Lehman, recall) to declare–following in the footsteps of the US Treasury–that no financial institution deemed too big to fail should be permitted to collapse. So far so good, but she also took the position that the guarantees had to be enforced by each European state individual, not by the EU overall or the eurozone acting as one entity. You might argue that she had no choice–after all, the EU did not then and does not now have a “Treasury”–but the seeds of the crisis were sown.

And Soros nails the problem:

There is some similarity between the euro crisis and the subprime crisis that caused the crash of 2008. In each case a supposedly riskless asset–collateralized debt obligations (CDOs), based largely on mortgages, in 2008, and European government bonds now–lost some or all of their value.

Unfortunately the euro crisis is more intractable. In 2008 the US financial authorities that were needed to respond to the crisis were in place; at present in the eurozone one of these authorities, the common treasury, has yet to be brought into existence. This requires a political process involving a number of sovereign states. That is what has made the problem so severe. The political will to create a common European treasury was absent in the first place; and since the time when the euro was created the political cohesion of the European Union has greatly deteriorated. As a result there is no clearly visible solution to the euro crisis. In its absence the authorities have been trying to buy time.

Normally buying time is a sane tactic as one hopes for fear and panic to recede. But this crisis has been going from bad to worse, as a continual series of fixes and proposed fixes that might have been sufficient had they been implemented sooner are not deemed politically feasible until the crisis has escalated, at which point the fix is clearly inadequate, leading to greater escalation of the crisis, another abortive, too-little-too-late response by the powers that be, and so on.

It takes a crisis to make the politically impossible possible. Under the pressure of a financial crisis the authorities take whatever steps are necessary to hold the system together, but they only do the minimum and that is soon perceived by the financial markets as inadequate. That is how one crisis leads to another. So Europe is condemned to a seemingly unending series of crises. Measures that would have worked if they had been adopted earlier turn out to be inadequate by the time they become politically possible. This is the key to understanding the euro crisis.

I noted earlier that there is no such thing as an EU “Treasury,” but the nascent formation of one may be under way, under the guise of the European Financial Stability Facility (EFSF)–agreed on by twenty-seven member states of the EU in May 2010–and its successor, after 2013, the European Stability Mechanism (ESM).

But again we have a structural problem, illustrating yet again for the umpteenth time this century the ineluctable power and vast reach of the Law of Unintended Consequences.

To wit, the EFSF can only extend low, concessional borrowing rates to countries deemed (by the EU as a whole) worthy. At the moment Greece is on that fortunate list, but Italy and Spain are not–with the result that the latter two countries are having to pay higher and higher market-based risk premium rates, which only increases the odds of their having to default, “offer” their debtholders a non-negotiable haircut, or take other drastic action. In other words, withholding the lifejacket until the swimmer has gone under for the 2nd time is a recipe for making the crisis worse.

So what’s to be done?

With the caveat that I would take almost anything George Soros writes about himself or his own career with a warehouse of salt, when he cares to be an objective commentator on financial conditions he (even he!) cannot control, he can be a brilliant analyst.

If you assume that the unthinkable is now possible (for example, Greece, Ireland, and Portugal, just for starters, could “resign” from the Eurozone), then you quickly get to these points:

To prevent a financial meltdown, four sets of measures would have to be taken. First, bank deposits have to be protected. If a euro deposited in a Greek bank would be lost to the depositor, a euro deposited in an Italian bank would then be worth less than one in a German or Dutch bank and there would be a run on the banks of other deficit countries. Second, some banks in the defaulting countries have to be kept functioning in order to keep the economy from breaking down. Third, the European banking system would have to be recapitalized and put under European, as distinct from national, supervision. Fourth, the government bonds of the other deficit countries would have to be protected from contagion. The last two requirements would apply even if no country defaults.

Pithy.

What, then, stands in the way?

Primarily–and agreement on this seems to be universal, regardless of which practitioner is prescribing which remedy–the willingness of Germany to go along. As the EU’s #1 economy without peer, and a bastion of fiscal prudence, without German participation nothing meaningful can happen.

A structural problem with the EU is, as noted, that there is no Treasury. Economics abhorring a vacuum, one must be created and now is the time if ever.

There is no alternative but to give birth to the missing ingredient: a European treasury with the power to tax and therefore to borrow. This would require a new treaty, transforming the EFSF into a full-fledged treasury.

That would presuppose a radical change of heart, particularly in Germany. The German public still thinks that it has a choice about whether to support the euro or to abandon it. That is a mistake. The euro exists and the assets and liabilities of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain. The longer it takes for the German public to realize this, the heavier the price they and the rest of the world will have to pay.

What are the alternatives?

All those with bright(er) ideas ought to speak up now, or forever hold their peace.

Update: 20 September 2011:

Today’s Wall Street Journal reports some jaw-dropping statistics about Europe. Well, it’s in an opinion piece by Bret Stephens on the op-ed page, but I’m not citing it for what he thinks (that the Euro is doomed and the Eurozone certain to break up) but for fact.

These numbers bring new puissance to the consequences of what it means to be a “welfare state:”

In 1965, government spending as a percentage of GDP averaged 28% in Western Europe. Today it’s nearly 50%.

In 1965, the fertility rate in Germany was 2.5 children per mother–a healthy replacement rate and then some. Today: 1.35.